Monday, March 13, 2017

Analysis for dynamic balanced portfolio using sector rotation - Still dicey as heck!

Current Commentary/Analysis For:

## [1] "March 13 2017"

Origin Process Current Review

Paired correlation of the six month run shows the offset of US Treasurys (UST) to SP500 will not be effective, so the UST weight is 0%. (See the Origin Process rates and yield curve analysis.) The only sector that the US Treasury now provides portfolio offset with negative correlation towards is finance (XLF). The key risk reward conusmer staples (XLP) has a positive correlation to long duration US Treasury (TLT), which means there is no offset likely for an adverse move in equities from a US Treasury weight.

The SP500 sectors in the 6 month time frame shows the market rally since the election has most of the return from the XLF (finance) ETF sector, and since active management is not additive. Or, in other words, the market return is not based upon portfolio construction but is dependent on the digital of being long or short finance (XLF). Based on the data for this last rally - six months to date - the “Equal Weighted Portfolio” (EWP) shows market return but less risk (see the 6 months frontier below) showing active management is not additive. The current market is a speculators market only, and to discuss portfolio management now and apply active portfolio management is at best naive or likely lacking integrity.

This has been further exacerbated by the recent post-“State of the Union” address to Congress surge in finance which has near singlehanded pulled the market to further heights, around 2300. But the following shows this is almost solely a finance sector market (XLF).

Since US Treasurys are “blown” and still too rich to provide a hedge or potential offset to a business cycle downturn, the ability to take equity risk is reduced or even nonsensical. Basically it is as operating in a high wire act without a safety net.

The market is speculative and 88% of the portfolio is cash with 5% in finance and 5% industrials.

What follows is an analysis of the graphing of the efficient frontier, the optimized weights for the allowed assets, and an analysis of volatility and the overall analysis of the correlation between US Treasurys and the SP500.

Using the correlation and the volatility of the assets, a frontier of the optimal portfolios are mapped for 6 months, 1 year, 3 years.

Currently the 6 months frontier is “swamped” by finance (XLF) with some outward bowing of the frontier to the left in the last week, but the EWP being to the left of the frontier shows that active management is not value added now. If timing was not applied since the election on the finance sector (XLF), this rally would not have resulted with good risk adjusted returns portfolio of more than two assets. And since the absence of US Treasury negative correlation which reduces risk taking, and since only 2 sectors are showing in the histograms below, the market is speculative and does not justify the equity bets as per active management. For the most, cash is the best risk qualified return.

The market is speculative and the portfolio has maximum cash weights. However in the last few weeks the 6 months frontier is developing more of an outward bowing than just after the election and soon cash positions, likely after a correction in equity, will be greatly reduced.

The one year efficient frontier graph with little curvature and almost a vertical shows the market is speculative and justifies a large cash weight. However the flat vertical is starting to slope to the right but it is a one factor effect from finance, now at 50% annualized return. However large banks are still near or even under book value so a “short” of XLF is not a sure thing simply because the return has been so extraordinary.

The model will be run daily and the cash position will be reduced when a “normal” outward bowing curve appears, likely first appearing in the the 6 month graph.

As the two years and less frontier graphs are in this 3 year graph, by definition shape, then the weights of assets that are the optimization solution when cash weight is reduced will likely be close to the three years histogram of portfolio weights, provided below. This will likely have consumer staples as the main weight.

Histograms of the above time periods show the weights for the least risk solution portfolio and the risky solution of the tangent line portfolio.

The first set on 6 months of data shows what sectors are driving the vertical frontier graph given above - finance and tech. And affirms the that the market is very speculative.

6 Months data histogram of weights for the optimized portfolio:

One year of data histogram of weights for the optimized portfolio:

Three years time span, staples sector become a keystone weight and finance and tech become drivers of more return realized with added risk.

This suggests that once the level of speculation drops, showing a more outward bowing efficient frontier, the weights likely will be finance, tech and consumer staples.

Three years of data histogram of weights for the optimized portfolio:

The above frontiers and optimal weights provided are put through a backtest for the last ten years. This is not forward looking but is plotted to see if there is a coherent structure to the optimized portfolios over time, such that active management is useful.

And good results for active management shows the use of US Treasurys and then reweighing to more optimal equity sector mix can keep pace with the index - the SP500- yet result in about 65% of the index risk (the backtest shows 61% for the last 10 years).

Note that in theory the main tool of reducing risk is the use of US Treasurys (TLT). Since US Treasurys are relatively the same credit quality as SP500, this explains why investors will accept US Treasurys yields of about 1/2 of SP500 yield. That differential is the price for the US Treasury insurance in for those economic downturns.

The “drawdown” of the theoretical backtested portfolio shows that in theory the model recommended weights that would have resulted in 50% of the market loss - the index SP500.

The summary of the above in the backtest plot shows the potential for good risk adjusted returns in comparison to the index, the SP500 with the Origin Process active management. Past returns and certainly not backtesting is no indication of future returns realized, they only frame the analysis of the portfolio process.

A theoretical “what if” test where the backtest is applied to only equity and with no US Treasurys. This shows the usefulness of US Treasurys during major index downturns, or recession. A sector dynamic re-weights into US Treasurys does reduce risk. However US Treasurys are currently several sigmas rich and as the Fed normalizes rates large downward jumps are occurring. Currently no US Treasurys are used in the portfolio.

The backtest for this two asset portfolio, SPY and TLT (long duration US Treasurys) is derived.

Return and correlation is graphed. The offset of US Treasurys is missing as summed up in the rolling 2 months correlation graph. US Treasurys are not providing offset to equity.

The correlation grids are repeated.

This supports the 0% weight of US Treasurys now.

The realized vol for the SP500 is graphed for short dated to long term. The vol shows levels of near historical lows which when combined with the vertical graphs above affirm the max cash weights.

US Treasurys vol is mapped in comparison to SP500 vol. The extraordinary low volatility for both assets classes is shown and that SP500 volatility is two low in relationship to US Treasury vol.